Post-Keynesian Ideas For A Crisis That Conventional Remedies Cannot Resolve

Monthly Archives: November 2012

I thought I should share what I found recently about who was to state the sectoral balances identity first – since it comes across as enlightening to say the least. I found the identity in Nicholas Kaldor’s 1944 article Quantitative Aspects Of The Full Employment Problem In Britain. It was published as Appendix C to Full Employment In A Free Societyby William Beveridge.

The ‘net’ is net of consumption of fixed capital. Also ‘balance of payments’ is used for the current balance (footnote 1, page 28). (In TheScourge Of Monetarism, Kaldor used ‘net saving’ as saving net of investment).

Anthony Thirlwall wrote a biography of Kaldor in 1987 and he mentions that Kaldor kept pushing the implications of the identity in the 1960s (page 251). He managed to convinced some of his colleagues such as Wynne Godley and Francis Cripps and pick up public fights with others such as Richard Kahn.

Wynne Godley recalled how he came to appreciate this identity in his book Monetary Economics with Marc Lavoie. In Background Memories (W.G.) he wrote:

… In 1970 I moved to Cambridge, where, with Francis Cripps, I founded the Cambridge Economic Policy Group (CEPG). I remember a damascene moment when, in early 1974 (after playing round with concepts devised in conversation with Nicky Kaldor and Robert Neild), I first apprehended the strategic importance of the accounting identity which says that, measured at current prices, the government’s budget deficit less the current account deficit is equal, by definition, to private saving net of investment. Having always thought of the balance of trade as something which could only be analysed in terms of income and price elasticities together with real output movements at home and abroad, it came as a shock to discover that if only one knows what the budget deficit and private net saving are, it follows from that information alone, without any qualification whatever, exactly what the balance of payments must be. Francis Cripps and I set out the significance of this identity as a logical framework both for modelling the economy and for the formulation of policy in the London and Cambridge Economic Bulletin in January 1974 (Godley and Cripps 1974). We correctly predicted that the Heath Barber boom would go bust later in the year at a time when the National Institute was in full support of government policy and the London Business School (i.e. Jim Ball and Terry Burns) were conditionally recommending further reflation! We also predicted that inflation could exceed 20% if the unfortunate threshold (wage indexation) scheme really got going interactively. This was important because it was later claimed that inflation (which eventually reached 26%) was the consequence of the previous rise in the ‘money supply’, while others put it down to the rising pressure of demand the previous year …

So the news is that Mark Carney – the Governor of the Bank of Canada will now be the next Governor of the Bank of England.

Wynne Godley would have been happy – had he been alive and known that Carney is perhaps the only central banker to have recognized his foresight. (Carney probably is also the only central bank head to have named some names.)

… Few forecast these events; although, in an outbreak of retrospective foresight, an increasing number now claim they saw it coming. The reality is that among all the banks, investors, academics and policy-makers, only a handful were able to identify ahead of time the causes and potential scale of the crisis. …

with an attached footnote:

Examples include Bill White, formerly of both the Bank of Canada and the Bank for International Settlements; Harvard University’s Ken Rogoff; Nouriel Roubini of New York University; Wynne Godley of Cambridge; and Bernard Connolly of AIG Financial Products.

So Karl Whelan wrote another article on TARGET2 claiming once more that a loss of TARGET2 claims of the Bundesbank does not matter at all to Germany. He has a new paper as well. Earlier he was arguing there was no loss at all.

His argument roughly is that since there is no longer trade settlement in gold, money is thence fiat and the loss does not matter.

Closed economy monetary economics is confusing enough for most monetary economists but when matters of open economy are discussed, it is a Herculean task for them to make sense of simple things. Some economists are better but end up making a mess.

First there is this story of “fiat money”. Supposedly after 1973 – when the Smithsonian Agreement broke down – money or currencies became fiat according to many theories. I guess this is generally the notion made popular by Austrian economists as far as I can tell and (is the root of all evil in this story). But this is strange. If “fiat money” has any meaning to it, money was equally fiat before – either during the Bretton Woods system or in any monetary institutional setups before that. So the US Dollar was as fiat as in 1920 as in 2012. There’s no meaning to saying that currencies became fiat suddenly.

Of course, in the Bretton Woods system, nations’ governments were required to redeem official foreign balances either in gold (till 1968), SDRs (after 1968) or in the currency of the member making the request (if any). In addition, there was a system of market convertibility in addition to official convertibility. In addition, the US volunteered to convert official foreign balances to gold till 1971.

So one could say that international trade was settled in gold. However, since money is credit, international trade would also settle by borrowing from foreigners – not just the official sector borrowing but other resident sectors borrowing from foreigners. The proper way to understand this is to study how balance of payments accounting is done and it was no different now than what it used to be.

A nation which runs a trade deficit need not lose gold reserves because the current account deficit could be financed via the financial account. If there is a problem in inflow, changes in interest rates by the central bank would attract funds from foreign financial centers.

More generally as always, it is income changes which works to bring imbalances back to balance. Sometimes things get out of hand, leading to a loss of gold reserves and the need for international financial help for exceptional financing of the balance of payments. But even in the supposedly new fiat world, things can get out of hand and require exceptional financing transactions.

Before Bretton Woods, nations had less formal agreements and typically the central bank and/or the government would promise to convert currency notes into gold at the request of the holder and not just official balances. It was thought that this made currencies acceptable and that the central bank should not issue more currency notes than the amount of gold they held. This story however, has no empirical support. It was however thought that the amount of currency notes is some multiple of the amount of gold and perhaps this is the origin of the story of the multiplier. But this is a troublesome story and there is some sort of view that money is exogenous in such monetary setups but endogenous otherwise – which makes no sense at all. Money is always credit-led and demand-determined and hence endogenous.

[To be more complete, some nations do not have a legal tender of their own and use other currencies as per law]

Now, economists argued that in the era of fixed exchange rates, an outflow of gold would lead to an automatic contraction of the money stock – the underlying theory being that of the money multiplier. This is presented as the Mundell-Fleming approach. Wages would reduce and this will lead to more competitiveness in international markets and bring the trade imbalance back into balance. This didn’t work because the whole notion was based on ideas of the money multiplier and notions such as that. (In addition it ignores the crucial aspect of non-price competitiveness).

So Emperor’s New Clothes – economists figured that floating exchanges would do the trick. Even a great economist such as Nicholas Kaldor believed so (while he was warning about troubles with the Bretton Woods system in the 1960s) but he was the first to point out that it doesn’t do the trick – soon in the 1970s.

More troublesome is the notion that if a nation is indebteded to foreigners in the domestic currency, it doesn’t owe foreigners anything and that this debt is just technical. The reason given is that nations are relieved to convert balances of foreign governments and/or central banks in the new era (the ones floating their exchange rates). But this is highly mistaken. While it is untrue (official convertibility still exists), it ignores the more important concept of market convertibility. The “reason” is dubious. It is true that it doesn’t cost the central bank anything if banks ask for currency notes to satisfy the demand for their customers, it doesn’t mean much. The private sector net wealth and aggregate demand is affected by net government expenditures and precisely when the nation has a balance of payments crisis, does the government have less power. It however is useful to have the government to make expenditures and take other emergency actions to handle a crisis in the external sector (with the exception of governments in a monetary union and nations which have “dollarization”). Debt denominated in domestic currency is useful for another reason. Assuming foreigners do not repatriate funds abroad when the currency is depreciating, it prevents a revaluation loss on liabilities. Indebtednesss in foreign currency on the other hand, leads to revaluation losses – implying more is needed from export receipts to prevent the debt from getting out of hand.

The fact that in any monetary setup nations face a balance of payments constraint has led nations to grow via success in international trade. Those who understood this trick early gained market and their success led to more success. This in turn puts a handicap on the rest of the world. The ‘mercantalist’ nations while didn’t believe the invisible hand (according to Keynes) nevertheless gain tremendously from the present system of free trade. As long as free trade is maintained, it is advantageous to nations to have strong external positions – in trade and in claims held on foreigners.

Now to the paper of Karl Whelan.

For Whelan, the external assets of a nation – including the claims of the government on non-residents – does not matter at all.

When considering the loss of the Bundesbank’s TARGET2 claim, it is important to distinguish between implications that matter and those that don’t. Most of the commentary on this issue has focused on implications for the Bundesbank itself and the need for a hugely costly recapitalisation of the central bank. For example, Burda (2012) argues that “Germany has now become a hostage to the monetary union, since a unilateral exit would imply a new central bank with negative equity.” However, there are a number of reasons why the capital position of the central bank is something of a red herring when considering a break-up scenario.

The first reason for this is that despite the common belief that central banks need to have assets that exceed their notional liabilities, there is no concrete basis for this position. Systems like the Gold Standard required a central bank to “back” the money in circulation with a specific asset but there is no such requirement when operating a modern fiat currency. A central bank operating a fiat currency could have assets that fall below the value of the money it has issued – the balance sheet could show it to be “insolvent” – without having an impact on the value of the currency in circulation. A fiat currency’s value, its real purchasing power, is determined by how much money has been supplied and the factors influencing money demand, not by the central bank’s stock of assets. As discussed in the attached box, close examination reveals little merit to the various arguments that are put forward for the idea that a central bank must have positive capital to achieve its goals.

The second reason the focus on central bank capital is a red herring is that, even if it is decided after a break-up that Germany must recapitalise the Bundesbank, rather than being hugely costly, this recapitalisation would have no impact on either the net asset position of the German state or its budget deficit. Let’s assume the German government recapitalises the Bundesbank by providing it with an interest-bearing government bond. While the government’s gross debt will increase, the government bond becomes an asset of the Bundesbank, so the total public net debt does not change.

Similarly, suppose the new debt provides interest payments of €3.9 billion (equal to the annual interest that would be generated by the September 2012 level of Bundesbank net Intra-Eurosystem claims). This payment would raise the profits of the Bundesbank by this amount, thus raising the amount the Bundesbank can return to the German government by the same amount, resulting in no change in the budget deficit.

So the issue facing Germany in case of a loss of its Intra-Eurosystem claims is not the insolvency of the Bundesbank or the costs associated with recapitalising it. The real issue is simply that the Bundesbank had a large asset and this asset will have disappeared. Still, despite the eye-popping level of the Bundesbank’s TARGET2 claim, the disappearance of the net income from the Intra-Eurosystem claims would have a very modest impact on the annual German budget. At an interest rate of 0.75 percent, the yield of €3.9 billion on the net Intra-Eurosystem claims of €516 billion as of the end of September represents only 0.15 percent of German GDP. Rather than a huge potential loss keeping Germany hostage within the Eurozone, I suspect this is a loss than many Germans would shrug off as perhaps being smaller than the likely costs associated with the sovereign bailout funds aimed at saving the euro.

Although Whelan accepts there is a loss (although he wasn’t earlier), there is hodge-podge here in the whole write-up. Whether there is gold involved in settlement of international debt or if the government promises to convert currency notes into gold (to keep its currency acceptable and which is just an illusion in any case) is an entirely irrelevant issue. The potential of a loss of huge amounts (given that a panic can lead to further losses for the German public sector – to see how see this post) is dreadful to Germany. The seigniorage calculation is hardly useful. It is like telling someone that a $1m loss doesn’t matter because it only earns $2,500 per year – given current interest rates. His point that there is “no change in the budget deficit” if Bundesbank’s foreign assets get replaced by German government debt has a simple calculation mistake – in one case the public sector is receiving interest income from abroad and in the other it isn’t.

Edited 22 Nov 2012 7:35am GMT

(Apologies for misspelling Whelan earlier in some places in earlier version)

I came across this presentation of Joe Stiglitz (from INET earlier this year) today as someone referred to it on Facebook. I think I may have referred to it earlier. Stiglitz is certainly one of the better economists in mainstream. The presentation is at Business Insider with the title Joe Stiglitz’s Presentation On Why The Entire Global Economic System Is Doomed To Fail – which I think was a nice heading!

The world is severely imbalanced as a result of the promotion of free trade and this has led to debtor exhaustion (borrowing words from Stiglitz). Deficit nations are in a position where they cannot expand domestic demand unilaterally because sooner or later they will run into a balance-of-payments crisis. Surplus nations on the other hand are showing no inclination to do fiscal expansion. Till now the United States was acting as an “importer of the last resort” or a “demander of the last resort” and this allowed the world to grow. But faced with its own balance of payments problems, it is not easy for the United States to grow. The rising public debt (as a counterpart of the rising net indebtedness of the United States to the rest of the world caused due to the United States’ balance of payments) will not be promoted by the Federal Reserve – the exorbitant privilege of the United States has become a burden. This is not to say that fiscal policy will not help the United States but it cannot alone bring the nation back to full employment.

I absolutely love Nicholas Kaldor and I saw some nice things in the presentation (emphasized by Kaldor such as “learning by doing”), promoting industrial policy in the developing world and modifying the rules of the game for the world trade to allow nations to take unilateral action to prevent imbalances from getting out of hand (last slide in the presentation). Kaldor himself (and his “New Cambridge” group) had advocated import controls for the United Kingdom in the late 70s/early 80s.

Kaldor had an articulate way to put his ideas across. Here’s from his 1981 article The Role Of Increasing Returns, Technical Progress And Cumulative Causation In The Theory Of International Trade And Economic Growth (from his Collected Papers, Vol 9):

Traditional theory, both classical and neoclassical, asserts that free trade in goods between different regions is always to the advantage of each trading country, and is therefore the best arrangement from the point of view of the welfare of the trading world as a whole, as well as of each part of the world taken separately. [footnote: The latter part of this proposition abstracts from the possibility that a particular country possesses some degree of monopoly power and thereby can turn the terms of trade in its favour by means of a tariff even after retaliation by other countries is taken into account.] However, these propositions are only true under specific abstract assumptions which do not correspond to reality. Under more realistic assumptions unrestricted trade is likely to lead to a loss of welfare to particular regions or countries and even to the world as a whole – that is to say that the world will be worse off under free trade than it could be under some system of regulated trade …

… Owing to increasing returns in processing activities (in manufactures) success breeds further success and failure begets more failure. Another Swedish economist, Gunnar Myrdal, called this ‘the principle of circular and cumulative causation’.

[italics in original]

Although there are some right things Stiglitz says about international imbalances, he emphasizes monetary policy more than fiscal policy (something all mainstream economists do) and also suggests a global reserve system (the kind proposed by Keynes with a World Central Bank and all that). Economists have to wake up to the fact that monetary policy has a limited role to play and it is fiscal policy which matters. The idea of a world central bank won’t work – as emphasized by Kaldor (in the 60s!) because it would necessarily involve surrendering political sovereignty – governments won’t give each other unlimited credit lines to each other in such a system. (More on Kaldor and the world central bank some other time).

I have some commenters contacting me on the “About” and “Aspiration” pages on this blog recently and I thought this blog post should make my position clear that free trade makes everyone worse off. A closely related claim here (which will be defended again and again) is that over the long run, exports are the only source of autonomous demand. Because some nations get ahead of the others, this puts a severe handicap on others and new rules of the game is the only way out to prevent the general state of stagnation in the world economy (in between occasional periods of booms). Hence the title of the blog “Concerted Action”!

I think I had best begin by making my own position clear – I regard ‘monetarism’ as a terrible curse, a visitation of evil spirits, with particularly unfortunate, one could say devastating, effects on our country, Britain. The biological process of natural selection should make for the development of favourable traits in human character – and that includes the acceptance of ideas and beliefs that promote progress and the rejection of ideas that have the opposite effect. As we all know this is not, unfortunately, either a smooth or a continuous process – it proceeds by fits and starts. The religion of most societies contains the basic dualism between god and evil spirits, between angels and devils, between the purveyors of good advice and the purveyors of bad advice. The choice between them is often represented as a moral issue whereas it is more truly a matter of flair and intuition which sometimes works and sometimes does not. Decadence, according to Nietzsche, is a state in which the individual intuitively goes for the bad solutions for getting out of difficulties, and fails to pick out good ones.

The alarming thing is not that some people should hold crackpot ideas. The alarming thing is when crackpot ideas sweep the board – when they capture the minds of a wide selection of important and influential people. This has been the case with the rapid spread of monetarism among academics, journalists, bankers and politicians in the last five to ten years. It has also been the case with the rapid spread of racialism, the mass conversions of Fascist or Nazi ideas and ideals in the 1920s and 30s; and no doubt many other examples could be given. Ultimately the devil fails – at least this has been the case hitherto, otherwise we should not be here. But the cost is sometimes horrendous – whether through wars, revolutions or the misery and agony inflicted by mass unemployment, loss of opportunities, loss of skills or even loss of knowledge and know-how.

It is sometimes said that a fiscal union would be the best solution to the Euro Area crisis – perhaps it is the only solution. Indeed while the German leaders Angela Merkel and Wolfgang Schäuble have been trying to promote “more Europe” to achieve this objective, their plan is still defective since it is likely to be based on old plans of a political union.

The idea that the Euro Area needs a political union was known from before – as mentioned by the Werner Report from 1971. Nicholas Kaldor wrote an article in the same year (In The Dynamic Effects Of The Common Marketfirst published in the New Statesman, 12 March 1971 and also reprinted (as Chapter 12, pp 187-220) in Further Essays On Applied Economics – volume 6 of the Collected Economic Essays series of Nicholas Kaldor) highlighting the serious defects in the plan.

If the leaders of Europe are proposing to have a plan such as in the Werner report, then Europe is in more trouble. “What is not envisaged is that the main responsibility for public expenditure and taxation should be transferred from the national Governments to the Community.” According to Kaldor, this is bound to fail for reasons mentioned below.

I am reproducing here the relevant section of Kaldor’s essay (pp. 202-207) for the sake of completeness:

THE CONSEQUENCES OF A FULL ECONOMIC AND MONETARY UNION

The events of the last few years – necessitating a revaluation of the German mark and a devaluation of the French franc – have demonstrated that the Community is not viable with its present degree of economic integration. The system presupposes full currency convertibility and fixed exchange rates among the members, whilst leaving monetary and fiscal policy to the discretion of the individual member countries. Under this system, as events have shown, some countries will tend to acquire increasing (and unwanted surpluses) in their trade with other members, whist others face increasing deficits. This has two unwelcome effects. It transmits inflationary pressures emanating from some members to other members; and it causes the surplus countries to provide automatic finance on an increasing scale to the deficit countries.

Since exchange-rate adjustments or “floating rates” between members are held to be incompatible with the basic aim of economic integration (and are incompatible also with the present system of common agricultural prices fixed in international units) the governments of the Six, at their Summit meeting in The Hague in December 1969, agreed in principle to the creation of a full economic and monetary union, and appointed a high-level committee (the so-called “Werner Committee”) to work out a concrete programme of action.

The Werner Committee’s recommendations have not yet been adopted in detail, though its principal objectives have been confirmed by the Community’s Council of Ministers.

The realisation of economic and monetary union, as recommended in the Werner Report, involves three kinds of measures, each introduced in stages: monetary union, tax harmonisation, and central community control over national budgets. It envisages a three-stage programme, with each stage lasting about three years, so that the whole plan is designed to be brought into operation by 1978-80.

In the monetary field in the first stage the interest and credit policy of each central bank is increasingly brought under common Community surveillance and permitted margins of variations between exchange rates are reduced or eliminated. In the second stage exchange rates are made immutable and “autonomous parity adjustments” are totally excluded. In the third stage the individual central banks are abolished altogether, or reduced to the status of the old colonial “Currency Boards” without any credit creating power. [footnote: Different currencies (marks, francs, etc.) might be nominally retained so long as each currency has always a 100 per cent. backing in terms of the Community’s reserve currency.]

In the field of tax harmonisation it is envisaged that each country’s system should be increasingly aligned to that of other countries, and that there should be “fiscal standardisation” to permit the complete abolition of fiscal frontiers, which means not only identical forms but also identical rates of taxation, particularly in regard to the value added tax and excise duties.

In the field of budgetary control the Werner Report says “the essential elements of the whole of the public budgets, and in particular variations in their volume, the size of balances and the methods of financing or utilizing them, will be decided at the Community level”.

What is not envisaged is that the main responsibility for public expenditure and taxation should be transferred from the national Governments to the Community. Each member will continue to be responsible for raising the revenue for its own expenditure (apart from the special taxes which are paid to finance the Community’s own budget but which will remain a relatively small proportion of total public expenditure and mainly serve the purposes of the Agriculture Fund and other development aid).

And herein lies the basic contradiction of the whole plan. For the Community also envisages that the scale of provision of public services (such as the social services) should be “harmonised” – i.e., that each country should provide such benefits on the same scale as the others and be responsible for financing them by taxation raised from its own citizens. This clearly cannot be done with equal rates of taxation unless all Community members are equally prosperous and increase their prosperity at the same rate as the other members. Otherwise the taxation of the less prosperous and/or the slower-growing countries is bound to be higher (or rise faster) than that of the more prosperous (or faster-growing) areas. [footnote: A further reason for differences in the burden of taxation necessary to provide a given level of service lies in differences in demographic structure – e.g., some countries have a larger proportion of pensioners or schoolchildren than others.]

The Community will control each member country’s fiscal balance – i.e., it will ensure that each country will raise enough in taxation to prevent it from getting into imbalance with other members on account of its fiscal deficit. To ensure this the taxes in the slow growing areas are bound to be increased faster; this in itself will generate a vicious circle, since with rising taxation they become less competitive and fall behind even more, thereby necessitating higher social expenditures (on unemployment benefits, etc.) and more restrictive fiscal policies. [footnote: It is for this reason that in most countries it has been found necessary to transfer a rising population of social expenditure (on poor relief, education, roads etc.) from local authorities to the Central Government, and to supplement an increasing proportion of local tax revenues by grants from the Centre (such as the rate-equalisation grants in the U.K.).] A system on these lines would create rapidly growing inequalities between the different countries, and is bound to break down in a relatively short time. [footnote:To imagine the consequences one should ask what would happen if the inhabitants of each county in the U.K. were required to finance all their social expenditure by local taxes. Living in Cumerland would be enormously penalised; living in Surrey would be a tax haven.]

This is only another way of saying that the objective of a full monetary and economic union is unattainable without a political union; and the latter pre-supposes fiscal integration, and not just fiscal harmonisation. It requires the creation of a Community Government and Parliament which takes over the responsibility for at least the major part of the expenditure now provided by national governments and finances it by taxes raised at uniform rates throughout the Community. With an integrated system of this kind, the prosperous areas automatically subside the poorer areas; and the areas whose exports are declining obtain automatic relief by paying in less, and receiving more, from the central Exchequer. The cumulative tendencies to progress and decline are thus held in check by a “built-in” fiscal stabiliser which makes the “surplus” areas provide automatic fiscal aid to the “deficit” areas.

Even so, there is need for special regional policies – such as the U.K. differential grants and subsidies to the development areas – to alleviate the problems of growing regional inequalities. The need for the latter is recognised (in a vague way) in the Werner Report, which mentioned “community measures which should primarily concern regional policy and employment policy” and whose “realization would be facilitated by an increase in financial intervention at the Community level”. What the Report fails to recognise is that the very existence of a central system of taxation and expenditure is a far more powerful instrument for dispensing “regional aid” than anything that special “financial intervention” to development areas is capable of providing.

The Community’s present plan on the other hand is like the house which “divided against itself cannot stand”. Monetary union and Community control over budgets will prevent a member country from pursuing full employment policies on its own – from taking steps to offset any sharp decline in the level of its production and employment, but without the benefit of a strong Community government which would shield its inhabitants from its worst consequences.

Some day the nations of Europe may be ready to merge their national identities and create a new European Union – the United States of Europe. If and when they do, a European Government will take over all the functions which the Federal government now provides in the U.S., or in Canada or Australia. This will involve the creation of a “full economic and monetary union”. But it is a dangerous error to believe that monetary and economic union can precede a political union or that it will act (in the words of the Werner report) “as a leaven for the evolvement of a political union which in the long run it will in any case be unable to do without”. For if the creation of a monetary union and Community control over national budgets generates pressures which lead to a breakdown of the whole system it will prevent the development of a political union, not promote it.

But it would be also dangerous to dismiss the Werner Report on the ground that it is not likely to be implemented, particularly if Britain is inside the Community and will have a voice in deciding what happens. For the problems that led to The Hague decisions and to the Werner Report are genuine enough: the framework of institutions and arrangements which make up the present European Community do not constitute a viable system. The Community must either go forward towards full integration (via a political union) or else relax the rigidity of its present arrangements, particularly in regard to agriculture and exchange rates. And it would be hopeless for Britain to join the Community not knowing whether it wishes to move in one direction or the other.